While parts of the country bask in sweltering heat, inflation significantly cooled in June, raising hopes that the Federal Reserve might be able to curb rising interest rates and make that “soft landing” it wants to avert a recession.
According to data released Wednesday, the consumer price index (CPI) rose by 3 percent in the year through June, a decrease from the 4 percent increase recorded in May. This figure is also significantly lower than the roughly 9 percent peak experienced last summer.
The main contributing factor to this decline in inflation was the substantial drop in gas prices. However, there is a concern among policymakers that this decline could be temporary and therefore not indicative of long-term stability.
Core index reveals good news
To gain a more accurate understanding of the situation, economists often examine a more streamlined version of the CPI, which excludes food and fuel costs. Known as the core index, this metric revealed even better news than expected.
The core index surprised economists by exhibiting a lower rate of inflation than anticipated. This unexpected decrease suggests to some that inflationary pressures might be easing across a broader range of goods and services, indicating a potential slowdown in price growth. It offers a glimmer of hope that the current decline in inflation might not be transitory but rather a more sustained trend.
The news of slower inflation is undoubtedly positive for the economy. If inflationary pressures continue to cool, that would alleviate concerns about the Federal Reserve’s monetary policy tightening and the potential for rising interest rates. The Federal Reserve has been grappling with the delicate task of balancing the need to curb inflation with maintaining economic growth. A prolonged decrease in inflation could provide the Federal Reserve with more flexibility in its policy decisions.
But there are lingering questions about the sustainability of this inflation slowdown. Economists and policymakers are wary of attributing too much significance to a single month’s data, as short-term fluctuations can often occur. It remains to be seen whether this moderation in inflation is a temporary reprieve, or the beginning of a more stable and lasting trend.
A ‘temporary reprieve’?
“It’s likely only a temporary reprieve,” said Raymond Micaletti, chief investment officer at Allio Finance, in Seattle. “If interest rates stay high, U.S. government deficits will continue to grow and likely need to be monetized by the Fed – which will reignite inflation.”
If interest rates come down, Micaletti noted, the dollar will likely continue to weaken and liquidity-sensitive assets such as oil, gasoline, and other commodities will rise again
“And the next time oil soars, we won’t have the luxury of draining the Strategic Petroleum Reserve to increase the supply of crude and dampen the price,” he added.
So, the Fed’s fight to bring down inflation, which has obviously had some success, is far from over.
External factors, such as global supply chain disruptions, rising energy costs, and wage pressures, still pose risks to the inflation outlook. These factors could potentially reignite inflationary pressures and undermine the recent progress in curbing price growth. Additionally, the unprecedented fiscal stimulus measures introduced in response to the COVID-19 pandemic could have lingering effects on inflation dynamics.
“While headline inflation has eased significantly since last year, the sticky ‘core’ element has not declined by nearly as much,” said Adrian Cronje, Atlanta-based economist, author, and wealth manager. “In May, the Fed’s preferred gauge 1 showed a 3.8% annual headline rate, the lowest since April 2021, and a 4.6% annual core rate over the same period – a level that is still uncomfortably high. Based on a study of the bond market, where the yield curve
(the difference between short- and long-term rates) remains significantly inverted, and a comparison between the 10-year Treasury bond rate and the 2-year Treasury bond rate over time suggests that at least a short and shallow recession will ensue as the economy slows further.”
Inflation indicator questioned
But some investors have begun to believe that the inverted yield curve, which is traditionally an accurate predictor of a recession, may not be as good an indicator as usual.
“Contrary to widespread recession fears, the bond market is signaling that inflation is under control and recession odds are overblown,” said Jack Janasiewicz, portfolio manager at Natixis Investment Managers Solutions, in Boston.
“The service segment of the labor economy is seeing softening in wage growth, but perhaps not as fast as the market would like,’ he said, adding, “But with the Fed intently focused on wage growth in the services sector, this might provide a bit of comfort as the marginal improvement continues to persist in the right direction. The bond market is signaling something important – growth is holding up far better than most expected and recession odds continue to fade.”
Still others contend, there’s no reason to believe this time is different.
“Sir John Templeton is credited with saying the four most dangerous words in investing are, ‘This time it’s different,’ acknowledging there are fundamental laws with respect to risk and return that can bend for a while, but do not ultimately break,” said Micaletti. “With strong stock performance hinting at the beginning of a new bull market and an economy that has so far skirted a recession, everyone is wondering: Is this time different?”
Micaletti said his investment firm remains “underweight” in respect to long-run targets on equities and overweight in bonds and believes it is too early to increase the sensitivity of its fixed income exposure to declining interest rates.
Nevertheless, for consumers and businesses, a sustained moderation in inflation would provide much-needed relief. The cost of living and operating expenses could stabilize, allowing for better financial planning and investment decisions. It could also help restore consumer confidence and support increased spending, bolstering economic growth in the long run.
Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at email@example.com.
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